Key View: The National Bank of Romania's shift to a more dovish tone suggests less scope for additional interest rate hikes in the coming months. However, as inflation remains elevated, an overly accommodative monetary policy stance may force the central bank to return to a more aggressive tightening cycle in the longer term.

We have revised down our forecasts for Romania's key benchmark rate in 2018 to reflect the National Bank of Romania's (NBR) more dovish stance. The central bank surprised markets by choosing not to hike and keeping its key interest rate unchanged at 2.50% on August 6, while signalling that it's tightening cycle is drawing to a close. Addressing a liquidity shortage, the NBR also lent RON10.5bn (USD2.6bn) to 11 commercial banks, marking the biggest repo auction in over five years. That sent the three-month interbank Robor rate down 7 basis points (bps) to 3.25% ( see chart below). Against this change of tone, we now forecast the key rate to stand at 2.75% by the end of this year, which entails one more 25bps hike instead of two hikes as previously forecasted. Meanwhile, risks are increasingly tilted towards a lengthier pause in the tightening cycle.

Dovish Move Catches Markets By Surprise

Romania - NBR Key Rate And 3-month ROBID-ROBOR Rate, %

Source: Bloomberg, Fitch Solutions

The NBR's shift to a more accommodative policy in the coming months will be underpinned by concerns of a slowdown in economic growth. The gradual rise in borrowing conditions has contributed to the cool down which saw real GDP growth slump from a multi-year high of 8.8% y-o-y in Q317 down to 4.0% in Q118. The bank will also want to limit appreciatory pressures on the Romanian leu against mounting external imbalances that threaten the country's macroeconomic stability. The currency dropped to a two-week low against the euro following the NBR's meeting ( see chart below), underperforming other Central Eastern European currencies, a trend that is likely to remain in place in the coming months.

Efforts To Keep RON On The Weaker Side

Exchange rate - RON/EUR

Source: Bloomberg, Fitch Solutions

Inflation Risks Still Prominent

While consumer price growth will ease as supply side shocks abate over the coming months, inflationary risks stemming from still rising inflation expectations (fuelled by the recently announced regulated natural gas price hike) and Romania's tight labour market, will remain prominent. Adding to this, the government seems to be under no pressure to tighten its fiscal outlook, with further hikes in public wages scheduled for the coming quarters. Inflation lingered at 5.4% y-o-y for the second consecutive month in June, well above the NBR's 2.5%+-1 target, and we expect will remain near the upper bound of the target range going forward, standing at 3.5% y-o-y by end-2018.

Core Inflation Still Towering Above Peers

Core Inflation, % chg y-o-y

Source: Eurostat, Fitch Solutions

This suggests that the economy is not yet ready for an abrupt halt to the tightening cycle, and raises risks that the NBR may fall once again behind the inflation curve. Underpinned by this, we expect the central bank will need to somewhat backtrack on its dovish stance in the longer term, as reflected in our 2019 key rate forecasts which see further hikes in 2019. We project the key rate to be increased further to 3.25% by end-2019.